How IRC Section 1031 Impacts Your Real Estate Exchange Decisions

Researchers say the average adult makes up to 35,000 decisions every day. Some choices (like whether to make toast or pancakes) are simple. Others (like whether to buy a vacation home or an apartment building) are more complex. And still others are influenced by the tax code.

As a real estate investor, you want to make smart decisions that don’t trigger big tax bills. IRC Section 1031 is a very helpful tool for people who participate in the commercial real estate market. However, this option can impact the sorts of properties you buy and sell, along with who can help you along the way. It’s important to make sure you have a good plan in place before you begin the process.

What Is IRC Section 1031?

Internal Revenue Code (IRC) Section 1031 is an investment tool that allows for tax deferral on some very specific types of real estate transactions.

Per IRC Section 1031, gains or losses on the sale of an investment property are deferred if that property is exchanged for another that will also be used for an investment.

These are delicate transactions that require the coordinated sale of one property and the purchase of another. Typically, an investor identifies a property that should be sold and does so. The proceeds of that sale are held in trust while the investor finds another property and buys it. At that point, potential taxes that would be triggered by the sale (capital gains) are rolled into the new property. They only come due if that property is sold.

Can You Handle These Transactions Alone?

Many investors are adept at handling day-to-day purchases without help. However, if you choose to participate in a 1031 exchange, your ability to work alone is hindered.

If you accept any part of the funds from the sale of your property, the entire transaction becomes a taxable event. To circumvent this problem, investors enter an exchange agreement with a qualified intermediary (QI) who holds the funds until the sale is complete.

IRC Section 1031 deeply impacts how much outside help you need, and for some investors, that can be uncomfortable.

Which Properties Can You Include?

IRC Section 1031 can impact your decisions about properties you can sell and buy. While you may have many different assets on your roster that you’d like to sell off—along with properties you might want to buy—the rules are very strict when it comes to 1031 exchanges.

The Internal Revenue Service (IRS) explains that both properties involved in a 1031 exchange must be held for use in a business or as an investment. Properties that you plan to live in are typically excluded.

That means you can’t sell an investment property (like an office park) and purchase a residence (like your second vacation home). If you participate in a standard real estate sale and purchase, you could include anything you want. A 1031 exchange limits that ability.

Why Is Value Important?

In a traditional real estate transaction, you’re not required to buy something more expensive than the item you’re selling. IRC Section 1031 rules can influence your decisions about the property you plan to purchase.

In a Section 1031 exchange, the taxes you might face due to the sale of the property are rolled into the asset you buy. A sale like this can protect you from a tax bill. However, you could lose at least some of those benefits if the item you buy costs less and you take some of the funds as profit.

A gain in a Section 1031 exchange is a boot, and it’s taxable. You could achieve a boot by taking cash from the sale’s proceeds or accepting something else (like artwork) in exchange for a lower-priced item.

It’s critical to pay close attention to how much the item you’re planning to buy is worth, and that number should be higher than the amount of the item you’re selling. You should also have a plan for covering the gap between the sale profit and the purchase price. Some banks won’t provide loans for deals like this.

Why Is Ease of Purchase Important?

In a standard real estate transaction, you can bide your time and look for the perfect investment opportunity. When it comes, you can haggle and negotiate until you get the terms that appeal to you. Typically, the closing process alone can take at least 45 days. Sometimes, it takes longer. IRC Section 1031 can have a significant influence on that time frame.

Per IRS rules, you’re required to close on your replacement property within 180 days of the sale of the first asset. That deadline is fixed and can’t be shifted, even if you face delays that others might consider reasonable. If you miss the deadline, the transaction is subject to tax. Careful planning can help to prevent this outcome.

Following these rules can influence the type of property you purchase. For example, you may pull out of a deal with a difficult seller who is making too many demands and requiring too much time. You simply can’t afford to delay.

What Properties Can’t Be Included?

As we mentioned, IRC Section 1031 rules prohibit the purchase or sale of properties primarily used as personal residences or vacation homes. However, there are loopholes that could impact your planning for the future.

For example, you may want to use a Section 1031 exchange on your primary residence. How can you get started? You can convert this property into an investment, find a renter, and make money on it for several years. At that point, it’s officially a business property and can be legally included in an exchange.

Understand Deferred Taxes

Many people believe that IRC Section 1031 allows for tax forgiveness. That’s not true. The taxes you might be required to pay are deferred and rolled into the property you purchased. If you sell this property, that bill can come due.

A Section 1031 purchase is tricky to sell without tax consequences unless you use another exchange during the sale. If you use this process, you must think about the implications before you schedule the sale of the property.

You must also closely track your basis in the new property and your potential tax liabilities. That can mean hiring an accountant, ensuring that the person does the right paperwork every year, and keeping a close account of your obligations.

Get Help With Your 1031 Exchange

IRC Section 1031 rules are complicated, and even small mistakes can trigger big consequences. Get the help you need from 1031 Pros. We focus exclusively on these delicate transactions.

Our processes keep your money safe and secure while you find and purchase a new property, and our careful project management ensures that you have all of the documents you need when you need them. When you work with us, you won’t miss important deadlines, and you’ll find the process straightforward and smooth. Contact us to find out more and get started today.